When Accounting Fails: FTX, Fraud Risk and the Future of Audit Regulation

The Purpose of Accounting Law

In the UK, all non‑exempt companies must undergo an annual audit. The auditor’s duty is clear. They must obtain reasonable assurance that financial statements are free from material misstatement, whether caused by fraud or error, and issue an opinion accordingly.

This requires auditors to:

• Identify risks of misstatement
• Understand internal controls sufficiently to assess those risks
• Evaluate accounting policies
• Judge the directors’ use of accounting estimates
• Assess whether the financial statements present a true and fair view

Yet auditors are rarely held liable for failing to detect fraud. They are described as “watchdogs, not bloodhounds”. Directors are generally liable only to the company, not to third parties, unless they make direct representations. This leaves customers and investors exposed when companies act in bad faith.

The FTX Collapse: A Case Study in Accounting Failure

FTX’s collapse in 2022 is one of the most dramatic corporate failures in recent memory. The company is now in Chapter 11 bankruptcy and insolvent liquidation. Liquidators have recovered approximately $740 million. The fifty largest creditors alone are owed more than $3 billion. Most debts will never be repaid.

FTX used two accounting firms, Armanino LLP and Prager Metis. Neither identified or reported the breaches of policy or the misuse of customer funds.

John J. Ray III, the new CEO overseeing the bankruptcy, described FTX’s finances as “a complete failure of corporate controls”. Key failures included:

• No complete list of customer accounts
• Use of consumer funds to purchase property for executives and family members
• Misappropriation of customer assets to support subsidiaries
• Absence of basic governance structures

If the finances were in such disarray, auditors should have raised red flags. Their failure contributed to billions in losses.

Crypto Accounting: A Sector Without Standards

A major source of missing assets stems from the absence of official accounting standards for cryptocurrencies. Companies hold vast crypto positions. Tesla held more than $2 billion in bitcoin in 2021. Crypto assets are volatile, unregulated and prone to collapse.

FTX reported $5 billion in crypto assets. Within a week, that value fell to $649 million. When liabilities depend on asset value, volatility creates severe risk.

FTX also held large quantities of its own token, FTT. Although publicly traded, FTT had limited volume. When one major holder sold, the price collapsed. FTT lost 80% of its value almost instantly. FTX’s balance sheet imploded.

Volatile assets undermine:

• Mergers and acquisitions
• Lending decisions
• Solvency assessments
• Investor confidence

Standardised regulation for crypto accounting is urgently needed.

Accounting Reform: What Is Changing?

The UK is pursuing significant audit and corporate governance reform. The aim is to address monopolies, conflicts of interest and poor audit quality.

Public Interest Entities

A new category, Public Interest Entities, includes companies with more than 750 employees or turnover above £750 million. Reforms focus on these companies to reduce burdens on smaller firms while targeting those with the greatest systemic impact.

Challenger audits

The “big four” dominate the audit market. To counter this, the government proposes requiring PIEs that hire a Big Four auditor to also appoint a smaller challenger firm to conduct at least one third of the audit work.

ARGA: A new regulator

The Audit, Reporting and Governance Authority will replace the Financial Reporting Council. ARGA will have enhanced powers to:

• Investigate breaches
• Enforce corporate governance codes
• Impose fines and sanctions

Improved auditor training

Professional bodies will be required to strengthen training and skills to create a more effective audit profession.

These reforms remain proposals until legislation is passed.

Conclusion

FTX’s collapse is a stark reminder of the need for robust regulation and continual improvement in the audit profession. Fraud cannot be eliminated. Incentives for misconduct will always exist. But stronger oversight, clearer standards and sceptical due diligence can reduce risk.

Financial statements should never be taken at face value. In a world of volatile assets and complex corporate structures, scepticism is a professional necessity.